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Municipal bonds are known for their dependability. And after a banner year in 2011, they once again turned in a solid, if not record-breaking, performance, returning 6.6% in 2012 to date, according to a Barclays index.

Munis are also known for providing tax-free interest income. But heading into 2013, that fundamental tenet remains under genuine threat amid the ongoing, ineffectual fiscal-cliff talks in Washington.

"Everybody on Capitol Hill who we meet with says muni-bond taxability is on the [negotiating] table," says Mike Nicholas, who heads the Bond Dealers of America trade association and is part of the Municipal Bonds for America coalition lobbying to preserve muni tax exemption.

Since this column last explored the taxability issue a month ago ("Pondering Muni-Bond Taxes," Nov. 24), there's been frustratingly little further clarity regarding what will happen to munis next year. What has happened in the interim is a market selloff that began in early December and persisted through the middle of last week before munis stabilized.

Investors reacted by pulling $2.3 billion out of muni mutual funds and exchange-traded funds in the week ended Wednesday, according to Lipper data, their largest weekly outflow since late 2010 and the fifth-largest ever. Those funds had enjoyed inflows in 50 of the previous 52 weeks.

Plenty of factors contributed to the losses. The market probably needed to let off some steam after a year of gains and robust fund flows, especially as new muni-bond issuance was unusually heavy early this month. On Dec. 13 Moody's Investors Service downgraded Puerto Rico, a widely owned muni issuer, to just above junk status. Yields on Treasury bonds, which set the tone for muni-bond yields, also rose through early December.

Against this backdrop, it's hard to blame people for selling, especially if it means realizing some capital gains ahead of potential tax hikes. "We think that this week's flows are a temporary phenomenon and don't signal a return to the kind of mammoth, extended outflows that we experienced in 2010 and 2011," writes Chris Mauro of RBC Capital Markets. Others say fund managers remain reluctant to buy munis and prefer to sit on cash for now.

Investors keep returning to the taxation question. A higher income-tax rate looks likely for top earners regardless of what happens to munis. To the extent that it's possible to handicap muni outcomes, a proposal to cap muni tax exemption at a 28% tax rate looks like the front-runner for now. Such a cap "could more than offset any perceived benefit of higher marginal rates," write muni strategists at Morgan Stanley Smith Barney.

EVEN IF WASHINGTON DOES reach an accord and avert the cliff, Morgan Stanley says Treasury yields would likely rise and munis would likely underperform in the near term. Treasury yields continued their upward December creep last week, with the 10-year note yielding 1.770% Friday, up from 1.702% a week earlier, while the 30-year yield rose to 2.934% from 2.865%.

Whatever happens, any changes in tax treatment might make only a minimal difference for muni investors next year, given how many analysts are forecasting dismal 2013 returns for a wide variety of high-grade bonds now hamstrung by high prices and historically low rates that will likely rise at some point.

"We expect a more challenging 2013," Citi muni strategists caution this week, "since the margin of error is much smaller."